April 23, 2015 Chapter 12: Aggregate Demand II In this chapter, you will learn… - How to use the IS – LM model to analyze the effects of shocks, fiscal policy, and monetary policy - How to derive the aggregate demand curve from the IS – LM model - Several theories about what caused the Great Depression Equilibrium in the IS – LM Model - The IS curve represents equilibrium in the goods market o Y = C(Y – Tbar) + I(r) + Gbar - The LM curve represents the money market equilibrium o Mbar/Pbar = L(r,Y) - The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets Policy analysis with the IS – LM model - Y = C(Y-Tbar) + I(r) + G- Mbar/Pbar = L(r,Y) - We can use the IS – LM model to analyze the effects of: o Fiscal policy: G and/or T o Monetary policy: M An increase in government purchases - IS curve shifts right by 1/(1-MPC)delta G causing output & income to rise - This raises money demand, causing the interest rate to rise…- …which reduces investment, so the final increase in Y is smaller than 1/(1-MPC)delta GA tax cut - Consumers save (1-MPC) of the tax cut, so the initial boost in spending is smaller for delta T than for an equal delta G…- And the IS curve shifts by o (-MPC/(1 – MPC))delta T o … so the effects on r and Y are smaller for delta T than for an equal delta G Monetary policy: an increase in M - Delta M > 0 shifts the LM curve down (or to the right) - … causing the interest rate to fall - … which increases investment, causing output & income to riseInteraction between monetary & fiscal policy - Model: o Monetary & fiscal policy variables (M, G, and T) are exogenous - Real world: o Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa - Such interaction may alter the impact of the original policy change The Fed’s response to delta G > 0- Suppose Congress increases G- Possible Fed responses: o Hold M constant o Hold r constant o Hold Y constant - In each case, the effects of the delta G are different Response 1: Hold M constant - If Congress raises G, the IS curve shifts right - If Fed holds M constant, then LM curve doesn’t shift - Results: o Delta Y = Y2 – Y1o Delta r = r2 – r1Response 2: Hold r constant - If Congress raises G, the IS curve shifts right - To keep r constant, Fed increases M to shift LM curve right. - Results: o Delta Y = Y3 – Y1o Delta r = 0Response 3: Hold Y constant - If Congress raises G, the IS curve shifts right. - To shift Y constant, Fed reduces M to shift LM curve left. - Results: o Delta Y = 0 o Delta r = r3 – r1Shocks in the IS – LM model - Examples: o Stock market boom or crash Change in households’ wealth Delta Co Change in business or consumer confidence or expectations Delta I and/or Delta C- Examples: o A wave of credit card fraud increases demand for money o More ATMs or the Internet reduce money demand Case Study: The US recession of 2001 - During 2001, o 2.1 million people lost their jobs as unemployment rose from 3.9% to 5.8% o GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000) - Causes:o Stock market decline Decrease C o 9/11 Increased uncertainty Fall in consumer & business confidence Result: - Lower spending, IS curve shifted left o Corporate accounting scandals Enron, WorldCom, etc. Reduced stock prices, discouraged investment - Fiscal policy response: o Shifted IS curve right Tax cuts in 2001 and 2003 Spending increases - Airline industry bailout - NYC reconstruction - Afghanistan war - Monetary policy response: o Shifted LM curve right What is the Fed’s policy instrument? - The news media commonly report the Fed’s policy changes as interest rate changes, as ifthe Fed has direct control over market interest rates - In fact, the Fed targets the federal funds rateo The interest rate banks charge one another on overnight loans - The Fed changes the money supply and shifts the LM curve to achieve its target - Over short-term rates typically move with the federal funds rate - Why does the Fed target interest rates instead of the money supply? o They are easier to measure than the money supply o The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply IS – LM and aggregate demand - So far, we’ve been using the IS – LM model to analyze the short run, when the price levelis assumed fixed. - However, a change in P would shift LM and therefore affect Y The price level and real money - Higher price level lowers M/P, the amount of real money in the economy - People wish to restore their original level of real money holdings. o They will try to have more cash - Example: o If the average lunch price goes from $4 to $5 per day, then you will need to hold about $30 more per month to purchase your lunches - To get more cash, people sell their interest – bearing assets, which will lead to lower bond prices and higher interest rates - So higher price level o LM shifts upward - The effect is similar to that of a decrease in money supply An increase in P - An increase in P is similar to a decrease in M Deriving the AD curve - Intuition for slope of AD curve: o Increase P = Decrease (M/P) LM shifts left Increase r Decrease I Increase Y Monetary policy and the AD curve - The Fed can increase aggregate demand: o Increase M = LM shifts right Decrease r Increase I Increase Y at each value of P Fiscal policy and the AD curve - Expansionary fiscal policy (Increase G and or Decrease T) increases aggregate demand o Decrease T = Increase C IS shifts right Increase Y at each value of P IS – LM and AD – AS in the short run & long run - Recall from Chapter 10: o The force that moves the economy from the short run to the long run is the gradual adjustment of prices In the short-run equilibrium, if Then over time, the price level will Y > Y bar Rise Y < Y bar FallY = Y bar Remain Constant The SR and LR effects of an IS shock - A negative IS shock shifts IS and AD left, causing Y to fall - In the new short-run equilibrium, Y < Y bar - Over time, P gradually falls, which causes: o SRAS to move down o M/P …
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